## Tuesday, February 14, 2017

### UNDERSTANDING VOLATILITY

“And suddenly … Dick & Jane have an OMG! moment of clarity.”

After yesterday’s charts on gold volatility, I thought it would be helpful to most people to simply “step back” for a second and get you to really understand what “VIX” means for anything; stocks, stock indices, gold, FX, etc. right on down the list of everything on the MT4. Yesterday, gold VIX closed at something like 14.94%; for our purposes today I’m going to use the figure 15% to make the math somewhat easier to follow. So what does this “15” number mean exactly?

VIX = a statistical measurement known as a standard deviation [SDEV] that measures dispersion around a set of data; dispersion defined as the actual value difference of each data point from the average of all data points in the set. It’s a common practice in the financial trading arena to use the closing day’s price for each day of the last year.

So, here is how the gold VIX is calculated; 1) Calculate the average (simple moving average) price for the number of periods or observations, 2) Determine each period's deviation (close less average price), 3) Square each period's deviation, 4) Sum the squared deviations, 5) Divide this sum by the number of observations [this number is known as the Variance or “VAR”], and 6) The standard deviation is then equal to the square root of that number, which = VIX.

OK, so what does this “15” mean to me as a trader? It has 2 main functions; 1) as a measurement of “fear in the marketplace”, where the lower the number, the more stable in terms of pricing the day-to-day fluctuations in price are relatively speaking compared with other time periods, and the opposite of this where the higher the number the more unstable in terms of pricing the day-to-day fluctuations in price are relatively speaking compared with other time periods, and 2) pricing derivatives like options correctly correspondent with current perceived market risk.

Of course, all of this is fluid and dynamic and changes rather quickly given news flow and world events. Given the low relative measurement of gold volatility currently compared to past years, and the fact that the algorithm still has enough volatility to make money, how confident should we be that when the gold VIX starts to go up the algorithm should do even better? “Well, I think it’s a generally fair assumption”.

In a normal probability distribution, 68% of the observations fall within one standard deviation; 95% of the observations fall within two standard deviations; 99.7% of the observations fall within three standard deviations; therefore, if today’s or tomorrow’s close in gold were up \$30 per OZ. from the close, given the current price around \$1228, that would represent a more than 2 SDEV move and would push the Gold VIX higher. And if we start getting \$20 - \$30 per OZ. moves from the previous day’s close, I can guarantee intraday volatility will spike as well, giving us plenty of trade signals when prices are moving. And that’s exactly what we want!

Along with the “VIX” [gold or other markets], you’ll often hear another term used, and that is “skew”. Volatility skew is the difference in implied volatility (IV) [or current pricing in the market] between out-of-the-money options, at-the-money options and in-the-money options. Skew can occur via price and also time. Last Summer, when the upcoming “Brexit” decision was looming on June 23rd, there was a huge “skew” between spot gold puts/calls expiring before the 23rd and after the 23rd, for obvious reasons. At the time, the gold market was recording record levels of skew as were options in GBPUSD, as dealers and banks sought price protection from violent potential moves after the vote and hefty option premiums were priced accordingly.

“Well, I think there’s a lot of mating going on then in gold overnight”.

Turning to today’s gold market … crickets! … second day in a row where the HVALUE coming into the NY session is below \$5 … and if you think it’s bad in gold, take a look at USDJPY, GBPUSD, and practically all the stock indices; they are worse … I have no idea when VIX levels go back up significantly; what I do know is that they can’t stay down here at these historically low levels for long … history shows that, and unless we are moving into the calmest, most stable period in financial history, which I would argue is not happening, what is the over riding theme that is putting a lid on VIX across multiple asset classes?

Two things in my mind, although I don’t know how they break down to percentages; 1) Central Bank manipulation and outright paranoia over controlling asset prices and determining outcomes, and 2) extremely heavy selling of option premium by institutions and hedge funds desperate for yield at any price cuz they think the Central Banks “got their back”. Sooner or later, this isn’t going to end well, and it leads to absolute carnage in the marketplace when the “dam” breaks and volatility literally explodes higher very quickly.

I looked the other day at deep OTM [out of the money] calls in gold, and also deep OTM puts in the SP500 index; the “skew” is astounding in what these “tail risk” calls and puts are going for and the prices they are commanding. Upwards of 500% higher than what they should be priced at under the Black-Scholes option pricing model [the most popular and widely used model in the marketplace]; and so here we are with “everybody and their brother” long “tail risk” options [both sides with record open interest] and the market sitting. EXIT QUESTION: “Does the market [gold and/or stocks] let all these institutions and traders win with these bets”?

“And my guts and brains are screaming at me saying, ‘Hell no!’, there is no way; not back-in-the-day, not now, and not in the future. The purpose and function of markets is to screw the most people out of the most money as efficiently as possible that would make a central planner apoplectic with envy”.

“So, is this time different”? [“This time it’s different”! – the 4 most dangerous words in all of human history.]

[Note: I realize not everybody out there in “readerland” gets into option pricing with all of the “Greeks” [symbols for option terminology, not the guys sitting around a table in Athens drinking ouzo], and the implications & ramifications of pricing and their role in asset markets like gold; however, I do have quite a few “inquiring minds want to know” types, and for you folks there is a handy options pricing website that is easy to use and is free. Use the link directly below:

You can literally price anything into this and see what the various option pricing schemes are priced at and compare them to options pricing available in the marketplace; when values differ greatly, you’ll know immediately whether the trading public [institution & retail spec] is bullish or bearish on a market.]

Ok, that didn’t take long to escalate to DEFCON 1 from crickets; first trade of the day directly below.

Weird trade, you don’t see this often; first the mini-explosion, then 9 … yes, 9 in a row M1’s down without changing the price vector fields [white, yellow, & plum lines from up sloping to flat or negative], and then 9 in a row up M1’s to the high. I waited for the first M1 to turn red, and then I liquidated near the top.

And since then, during the last 80 minutes or so, all the market has done is drift sideways with tiny bursts either direction with zero follow through … and what’s telling me not to be a part of this? Easy Peezee: flat or out-of-sync signal lines with no M1 movements that fit the criteria of the algorithm. “Yes, the algorithm keeps you out of junk, and doesn’t want you to do stupid poo poo”!

If you spend any time at all watching gold [or USDJPY & GBPUSD for that matter], and paying attention to its “personality”; i.e. how it moves up and down, and how quickly the market moves and then seems to die down. There’s only one scenario for profit maximization; you have to get in “right” and exit on spikes that go in your profit direction. Waiting for “confirmation” that it isn’t going higher or lower anymore is an open invitation to give money away. And then comes the next important criteria; not caring what happens after you exit. NEWS FLASH: “nobody, including you or me, can consistently pick tops & bottoms. When the market hands you money you take it, and then you start all over again. Where gold is priced [higher or lower] can’t be deposited in the bank; it simply doesn’t matter if the price is \$1200 or \$12,000; what matters is the concept of ‘buying at 1 and selling at 3’ and pocketing the difference. NOW WERE TALKIN’!

Well, that escalated quickly; trade #2 directly below.

Lower exhaustion line hits are always “buys” in the gold algorithm; the key is once the market hits the exhaustion line wait for the M1 to turn green and then buy; equally important is selling the elevator back up on short covering. The quicker the better, and in order to get a decent fill liquidating, you can’t wait for the turn red, you have to sell into the rally.

And now right after this liquidation, although I didn’t make the trades, were 2 more sell signals with 3 green up M1’s followed by a move down scalp that could have netted a buck or more per OZ. in each one. Well, it’s about time things started heating up in this market!

Well, after these 2 trades, I’m done thank you.

Chamber of Commerce day down here … beach beckons … dog is going out of his mind he wants outta here [or maybe it’s the bacon] … until tomorrow …

Have a great day everybody!
-vegas